Why Investors Should Stop Watching the Index
When someone says “The Stock Market,” often the images that come to mind are screaming traders in blue jackets or a large mahogany desk perched atop the glass and steel of Wall Street’s skyscrapers. While everyone has a different image of the stock market, when gauging how well the market is doing, most investors think of the same two or three market indexes - The Dow Jones, The S&P 500, and The Nasdaq. These indexes are the ones constantly put in front of us via the news, radio, and investment statements.
These indexes often serve as benchmarks used to grade our portfolios and our financial advisors’ performance. It is human nature for us to want to know how well we are doing in any given task, let alone investing. The problem with using these three popular indexes as the comparison is that investors are often much more diversified and conservative than these “benchmarks.” Using the Dow, the S&P 500, and the Nasdaq as a benchmark can be problematic since each one of them has a fairly limited focus. The Dow Jones encompasses only 30 of the largest U.S. companies, and The S&P 500 contains 500 large U.S. companies. The Nasdaq composite index may seem to be more diversified as it contains over 1,000 companies, but it is market cap weighted and therefore highly concentrated. In fact, the top five companies in the Nasdaq make up nearly 40% of its composition (Apple, Microsoft, Amazon, Google, and Tesla).
In contrast to the concentration of those indexes, many investors are often far more diversified and own other asset classes inside their portfolio such as bonds, international stocks, small stocks, and hard assets. As investors add more and more asset classes to their portfolio, they broaden their diversification. When diversification is added correctly, investors will experience less correlation with the market and, ideally, less volatility. Investors should be conscious of the fact that a diversified portfolio will not mirror “the market,” and they should not want it to. By adding diversification, investors can often experience better long-term performance with less volatility.
It is pretty clear that The Dow, S&P 500, and The Nasdaq are not good benchmarks for diversified portfolios. However, what can be lost in that logic is how using those indexes as benchmarks can negatively influence investors via basic behavioral finance tendencies. When investors eagerly watch the indexes, certain tendencies can be created; such as short-term unrealistic return expectations in up markets (2021) and increased panic during down markets (2008). The emotions caused by these unrealistic return expectations and panic from down markets can lead to poor investment decisions driven by fear or greed. Warren Buffet was once quoted as saying, “Be fearful when others are greedy and greedy when others are fearful.” Despite Mr. Buffet’s common sense investing tip, study after study has supported his view that investors make poor decisions due to emotional reactions and, as a result, drastically underperform.
As an alternative to watching just these three indexes, investors should ask their financial advisor for data on a variety of indexes. By looking at indexes that represent a diversified portfolio, investors are better able to discern why their portfolios differentiate from the three major U.S. indexes.
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Written by Brice Carter